Apple’s Irrational Exuberance

Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The plethora of posts regarding the plunge in Apple's (NASDAQ: AAPL) share price is staggering. The main debate is if the decline was reasonable, and if the market correct? You can find an interesting post that explains why Apple’s tumble was over the top.  I think you can convince each side of the table for the correctness of the market or its irrational exuberance. I think the answer is less related to the evidence and has more to do with your beliefs. If you think Apple will come up with the next big product then yes, Apple will reach the $700 mark in 2013. If you believe Apple’s innovation isn’t likely to generate another great new and unexpected product, then consider this company for what it is: a great company with high growth and profit margins, much like other market leaders such as Google (NASDAQ: GOOG).

A Known Unknown

During January shares of Apple fell by nearly 14%. Back in September the stock reached the $700 mark. It’s well known that markets tend to demonstrate “irrational exuberance,” as former Fed chairman Alan Greenspan stated in 1996. I think this behavior can go both ways: for the market heating up and cooling down. So was the market’s reaction a bit over the top? Perhaps, but if you subscribe to this notion then the spike in the company’s stock back in September could have been just as easily the same form of  exuberance. If you believe in the whole efficient market hypothesis with all its caveats, then the market’s reaction to Apple’s financial report is just a correction to the current belief of where the company is headed.

This all comes down to one of the main uncertainties regarding the company: growth. You can more or less know the “steady state growth” of Apple (one that assumes the company won’t come up with a new line of products, e.g. iTv, iGoggles, etc), its profit margin, and cash flow situation to determine the company’s crude outlook. The market reaction that came after the company developed its iPhone or iPad led to its meteoric rise. Apple will continue to bring great new products such as the iPhone 6 and iPad 4, but without a new line of products its high growth will slow down.

Dominance Threatened

Apple is still the leader in tablets and Smart-phone markets with nearly 47.8 million iPhones sold in the first quarter of 2013 (fiscal year) and 22.9 million iPads sold as well. This represents nearly a growth of 29% and 48.7%, respectively, compared to the same quarter in 2012. The high growth rates of these products lead to a lower growth in revenues of “only” 17.7%. This lower growth might have been due to price changes and unfavorable currency shifts. These high growth rates might fall as the competition in these markets intensifies with the launch of the Windows 8. Nokia’s Lumia, along with its Windows 8 platform, has demonstrated a sharp rise in sales in the recent quarter. Samsung is also expanding its market share, and for a market leader such as Apple growing will become much harder under these conditions. Just ask another market leader such as Intel (NASDAQ: INTC) or Microsoft (NASDAQ: MSFT). Both companies continue to dominate their respective markets, which allow them to have high profit margins but little growth. During the recent quarter Microsoft’s revenues grew by only 2.7%, and Intel’s revenues fell by 3%. 

Profitability

Apple’s profitability is high, but other leading companies also present high profit margins.  In the first quarter of the 2013, Apple's profit margin reached 31.6%. In comparison, other companies that have a strong hold on their respective markets such as Microsoft (in operating systems), Google (in the search engine market) and Intel (in the desktop and laptop microchips) reached 36%, 23.5%, and 23.4%, respectively. But these high profit margins aren’t driving these last three company’s stocks higher. Growth is the main factor.

Growth

During the last quarter Google’s revenues rose by nearly 36%. Apple’s revenues grew by 17.7%. For both companies the operating profit slightly declined. One of the main driving forces to reach growth is by R&D: in this aspect Apple is behind Google. In the recent quarter, the R&D out of net revenues for Apple reached 1.85%, and during the year it was 2.2%. Google’s R&D out of net revenues reached 11.8% in the last quarter and 13.9% during the year. At face value, Google is allocating a bigger chunk of its revenues to R&D compared to Apple. Granted, these companies’ “production function” isn’t the same, so the comparison might be misleading. Nonetheless, even in absolute terms Google spends nearly three times the amount of R&D that Apple does. If R&D could lead to new products, then Apple might be behind. So where do you believe the next big product will come from?      

I still think Apple is a great company as an investment. If you still believe this company will come up with the next i(insert product name here) or if you think the market’s reaction was partly a matter of irrational exuberance, then go with your belief; remember that your guess is as good as the market’s (or mine). If you think the market is efficient then take into account that the current price is the best estimate of Apple’s value, which could change in the future if new evidence comes to support it. I think the truth might be somewhere in the middle: the market’s reaction was over the top, but not by much.

For further Reading: Will BP make a Comeback?

Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.


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